China's A-share market has jumped back from its lows, but has this been because of improved fundamentals or the result of a harmful investor mentality fostered by a misallocation of capital by the country's huge underground funds industry?
At the end of 2001, the People's Bank of China estimated the underground fund management business to stand at RMB 700 billion ($84 billion), over ten times the size held in the official funds, and around 40% of the entire market.
The underground funds, run by former staff at the official fund companies and securities houses, have attracted capital from ultra-rich individuals as well as companies and banks. The underground funds are far more flexible in allowing investors to redeem their money compared to the legal closed-end funds, which until the advent of open-ended funds late last year, was all the legal fund management industry could offer. The underground funds also offer greater returns, 10-20% per year, but sometimes as high as 50%, compared to what the more realistic rates official funds could offer.
Their success hinges on their size.
After analysing the breakdown of the A-share free float in both the A-share market in Shanghai and in Shenzhen, Charlie Chen, then a Shanghai-based analyst for CLSA estimated last September that the underground funds held an incredible 30% of the free float, compared to just 4% by the legal funds.
The underground fund management's size means it can easily corner the small free-float and play with the share price. The small free float is due to two thirds of the $500 billion A-share market cap being non-tradable shares owned by the government and government related entities.
The government was initially keen to get back some of the money it has pumped into state enterprises, which make up 95% of listed companies and in which the government holds a stake of around 60%.
The sell-off, never formally announced, but starting in 2001, involved the government selling a chunk of government-held shares through IPOs and rights issues. However, this policy was not carried out in a systematic manner, due to instantaneous protests from the market. Protests were understandable, since government shares were previously classified as 'un-tradable', the aim being to maintain state control. So the policy to sell off state shares would have meant a massive expansion in the supply of shares and plummeting prices.
The Central Financial Works Conference set up in February this year to study China's many pressing banking and capital market problems, backtracked on this policy. The government could not afford to alienate investors by pursuing a policy which threatened to make the market crash.
"But postponing the sell-off is just delaying the problem, certainly not solving it," says Erwin Sanft, CLSA's head of China research.
And he adds, "Company fundamentals haven't really improved. The recovery is more to do with the Central Finance Works Conference confirming earlier rumours that it was not going to press ahead with selling down the government's stakes."
Since January, the A-share market has started performing strongly again. Standing at 1696.5 on April 26 (the last trading day before the Chinese May Day holiday), the Shanghai A-share market is well up from its year-low of 1475.5 on January 25.
But the size of the illegal fund management industry shows the A-share market is not dominated by individual investors, as often stated in the media.
"In fact, the underground funds use so-called individual accounts to minimize supervision risk and use the accounts for cross-trading to create artificial volume, " comments CLSA's Chen.
A very major plank of the government's reforms has been the creation of the ten funds management houses, running 47 close-ended funds and three open-ended funds with total assets of RMB 80 billion. These funds are much smaller than the underground funds, and more strictly supervised by the CSRC.
The small size of the official funds means that "underground funds are the almost the sole determinant of stock and market performance," according to Chen.
These underground funds have a nefarious effect on the stock market since investors wanting to make as much as possible as quickly as possible abuse their power.
These players can target certain shares and play with them like a tiger mauling a doll, buying up to 80% of the free float when they commence their operations.
The target shares are easily spotted, since they tend to show high levels of volatility, far outperforming the overall index in a rising market and subsequently sharply correcting when the investors cash out. Reflecting the market's contempt for fundamentals, a large-cap with sound fundamentals could trade as low as 20x P/E, despite the overall market trading at 60x P/E, if it's not the target of share price manipulation. In contrast, if a poor company is the target of share price manipulation, its P/E could jump to 120x. The goal of retail investors is simply to find out which companies are likely to be the target of price manipulation and buy in and out at the right time.
In setting up their price-rigging operations, the underground fund managers are helped by analysts and company executives themselves. The latter, for example, will be instructed to issue a profit warning, enabling the manipulators to buy the shares on the dip, while analysts are encouraged to issue research in line with the objectives of the manipulators.
Is the situation improving?
The CSRC is aware of the problems, but comes under enormous pressure from the powerful and well-connected underground fund managers. Still, it has introduced new corporate governance standards such as quarterly reporting and independent directors. It has also barred many securities houses from proprietary trading, depending on whether or not they have the full-service banking license, which stipulates a much larger registered capital requirement. With lower registered capital requirements, the other houses are restricted to pure brokerage services.
Lance He, a China analyst at CLSA, believes the most effective way of driving the underground funds out of the market is the encouragement of the open-ended funds.
"Gradually, the open-ended funds will suck the money out of the illegal funds, since the shares are easily redeemable," he states.
Still, while the underground fund management industry is still so powerful, and able to offer such high returns, it's going to be hard for the legal funds to compete. And that means the capital allocation mechanism in China will continue to reward companies irrespective of their true worth and extend an investing culture which ignores stock fundamentals.